JEDDAH, 28 February 2005 — Most publicly-held companies strive to report significant end-of-the-year net profits which do not necessarily reflect the true financial position of their operations.

Yet, earnings reports say little about a company’s true financial health. Yet these reports dominate — and distort — executives’, investors’, and auditors’ decisions. Corporate executives have the most to benefit in reporting “Net Income” and “Revenues”, simply because their compensation packages are tied to those figures. Stockholders are pleased to see their company’s press reports in the media, a reason to bid up the price of the stock. Accounting firms if they help a company increase its reported net income — sometimes by “cooking the books” they can usually count on retaining the company’s lucrative auditing business and maybe pick up a consulting contract as well.

The company’s selection of the accounting policies it employs in the preparation of its financial statements or in the manner in which those accounting policies are applied is very flexible, to say the least. The companies involved are simply using available flexibility in accounting principles in order to alter impressions about their company’s business performance.

Steady rise in earnings has become, at many Saudi corporations, an obsession in order to drive up the stock price and for directors to cash in their end-of-the-year bonuses.

Those reported figures are useless about a company’s future performance.

However, how true and authentic are those reported earnings? It is a proven fact that most companies “manage” their earnings to look good in public.

Thanks to the flexibility of accounting policies most companies using unusual accounting practices, in order to alter impressions about their firms’ business performance. Thus, assessments of corporate earning power can be rendered inaccurate.

The natural question is, why does flexibility exist? Why do accounting regulators permit companies to have such flexibility? Would it not make sense for regulators to require all companies to report their financial transactions in the same way?

Unfortunately, it is not that simple. Financial transactions and the economic conditions surrounding them are not sufficiently similar to warrant use of identical accounting practices, even by companies within the same industry.

Given the importance of revenue on the income statement, there is a wide latitude on how and when a company can recognize revenues. Improper timing of revenue recognition can be accomplished several ways. Keeping the accounting records open beyond the end of the reporting period so that the firm reports a higher revenue, changing the accounting method of revenue recognition and improper cut-offs.

In contrast, fictitious or fabricated revenues involve the recording of goods or services sales that did not occur. These sales involve fake customers, but also involve legitimate customers. The recording of fictitious sales of either real or unreal customers will result in the overstatement of revenues. Fictitious vendors, fraudulent invoices, and unsolicited sales are among the list of schemes that have been utilized by major corporations worldwide.

For example, revenue for ordered goods that have not left the seller’s warehouse might be recognized as though the goods had already been sent to the customer. Such an act would entail premature revenue recognition. Worse yet, product might be sent and revenue recognized in advance of an expected order. Given the lack of an order, such an act entails “fictitious revenue”.

Improper related-party transactions are often used close to year end. Example includes the recording of sales of the same inventory back and forth between manufacturing companies and their sales agents to “freshen” the receivables and sales with undisclosed commitments to repurchase.

Another marketing practice used to boost sales by persuading distributors to buy more inventory. Distributors are induced to overbuy with deep discounts, threats of losing purchasing benefits, or reduced purchasing ability of products.

Directors, accountants and regulators are struggling with the question of when revenue must be recognized.

Generally, revenue must be recognized when it is earned and realized. Revenue is earned when a company has accomplished what it must do to be entitled to the benefit represented by the revenue being recognized. Revenue is realized when goods and services are exchanged for cash or claims to cash such as a promissory notes.

There must be a persuasive evidence of an arrangement of sales/purchase between the seller and the buyer, delivery is certain to be occurred or services already rendered, and most importantly, the seller’s price to the buyer is fixed and collectibility of the sales revenue is certain.

Investors should be able to detect such improper accounting practices in many ways. One, check for the firm’s rapid revenues’ growth, unusual profitability, especially compared to that of other companies in the same industry. Two, the firm’s inability to generate cash flows from operations while reporting growth net income. Three, the firm reports unusual increase in gross margin (gross income divided by gross revenues) or margin in excess of industry’s average. Four, clients are not paying their bill on due time and constant delay is noticed (days receivables).

Why do companies manipulate their accounting figures?

Among the most common reasons are: To encourage investors to purchase their stock, to cover inability of the firm to generate cash, dispel negative market perceptions, obtain financing on favorable terms, meet company’s budget targets and most importantly, for directors to receive performance-related bonuses.

I am not accusing any specific company for committing any wrongdoing, all what I have done above, is to outline to you the various means by which a company can manipulate its revenues and net income. Therefore, a company that reports over the press those figures does not necessarily reflect the actual cash received. It is only paper profits.

(Abdelmenem Jamil Addas ([email protected]) is a professor of financial markets, at the College of Business Administration. He is based in Jeddah.)